- Private equity involves investing in businesses or funds not listed on public stock exchanges.
- Private equity investments offer high returns, but are illiquid and have high minimums.
- Traditional private equity is only open to the wealthy, but newer forms are available to smaller investors.
When you hear the words private equity, a few things probably come to mind: palatial estates, sleek suits, private islands, and, well, money. Lots of it. But if you're among those who think only characters from "Billions" can be involved in the world of private equity (PE), it's time to think again.
While private equity is still typically reserved for high-net-worth investors and institutional investors like pension funds, there are some ways for others to access this market.
Private equity investments are called "private" because they involve buying shares or an ownership stake in private companies or funds, rather than ones traded publicly on the stock market.
How private equity works
In many cases, private equity investments offer higher-return potential than public investments. That's partly because you may have the chance to invest in startups or growth-stage companies before they become household names, which can mean getting a good deal before their valuations balloon. For example, companies like Uber and Airbnb raised money from private equity funds before going public, giving those investors the opportunity to cash out for significantly more than what they invested at.
But even if you don't hit a home run like that, private equity returns still typically outperform public equity returns, due to factors such as less competition than public markets, the skill of some private equity firms at contributing to a company's growth, and the leverage used by some private equity investors to amplify returns.
However, this potential reward comes at a price. Private equity fees are often higher, the risk can be higher, the investments often have low liquidity, and there are generally more restrictions around who can invest in private companies and private equity funds, while at the same time there are fewer requirements around what the private equity sector has to disclose to the Securities and Exchange Commission (SEC).
Technically any investment in the ownership of a privately owned company is private equity, but this term typically refers to the private equity industry. In the private equity industry, investors often invest in private companies via private equity funds, run by private equity firms with specific investment strategies and areas of expertise.
Usually, private equity funds invest tens or even hundreds of millions in late-stage startups before they go public or more mature companies that will likely remain private but can be acquired by other companies or investors. In many cases, private equity funds buy a majority ownership stake in private companies and sometimes buy the whole company. This differs from venture capital funds, which invest smaller amounts for minority stakes in early-stage startups.
In essence, private equity funds gather large sums of money from investors who are usually in it for the long haul. This money is used to restructure or revamp a struggling company, fund acquisitions and start-ups, or take a company public.
Private equity often requires long investment holding periods, because it takes a while before projects like turning around a troubled firm or launching an initial public offering (IPO) can garner positive returns. In many cases, private equity funds hold investments for around three to five years.
Also, funds themselves usually have a lifespan of about 10 years. Unlike mutual funds that are typically open-ended and can buy and sell public stocks indefinitely, private equity funds often stop accepting new capital after reaching their funding goals and then make investments in companies before closing the fund permanently after about a decade. Meanwhile, the private equity firm might open a new fund to start sourcing new deals while the investments in the other fund run their course.
After the fund closes, investors — ideally — get their money back, plus any profits after fees. In certain cases, like that of a real estate limited partnership, investors may also earn regular income along the way, but most of the return is paid at the end.
Private equity investors
The vast majority of investors in a private equity fund are known as limited partners (LPs): They simply put up the capital, receiving an ownership stake or shares in the fund in return. In contrast, the fund's general partners (GPs) are responsible for managing and executing the fund's investments. They own a smaller percentage of the shares, too.
For example, BlackRock is a well-known investment manager that acts as GP for its private equity funds. LPs are generally those that invest in these BlackRock funds (or whoever the asset manager is), but not just anyone can be an LP. Usually, access to these funds is reserved for larger investors such as pension funds, university endowments, and some other investment firms like some hedge funds and mutual funds. Some GPs accept investments starting at around $250,000, while others require millions.
Even if GPs wanted to extend access, private equity investments are primarily limited to accredited investors, save for a few exceptions, like some crowdfunding campaigns. There are a few ways to qualify as an accredited investor, such as having a net worth of over $1 million excluding your primary residence, or earning $200,000 as an individual ($300,000 with spouse/partner) for the past two years with a reasonable exception to do so this year.
Investment strategies
Private equity investments take a variety of shapes. In many cases, though, funds have a specific strategy that they follow, such as the following:
Growth equity
Growth equity funds typically invest in companies that are still growing quickly but aren't early-stage startups anymore. These companies often have proven business models with reliable revenue and perhaps profitability, and they are on track for continued growth, potentially leading to an IPO or at least continued private valuation growth.
Distressed funding
Distressed funding deals with struggling businesses, such as those that have filed for Chapter 11 bankruptcy, allowing them to seek help by agreeing to restructure their business model and create a repayment plan for their debts. In some cases, private equity firms intend to help these businesses by changing up the management and turning the business around. In other cases, it's more about selling the business's assets for a profit.
Leveraged buyouts
One of the most common forms of private equity investment is a leveraged buyout (LBO), which involves the private equity fund borrowing money to acquire a business. Similar to distressed funding, LBOs also often involve buying a struggling business, but this time, the goal is typically for the business to improve its model before being sold for a profit or having an IPO.
Venture capital
Venture capital is sometimes considered its own category, but it can also be considered a subset of private equity. Venture capital involves investing in early to mid-stage startups so these portfolio companies can scale their businesses and ideally become IPO candidates or get acquired.
Specialized limited partnerships
Some private equity firms set up specialized limited partnerships that invest in specific types of assets. Real estate is especially popular for these funds. Specifically, they often invest in commercial spaces, or in multifamily structures like apartment buildings. Other private equity funds invest in infrastructure projects like bridges and roadways.
The private equity investment cycle
Private equity investments don't always follow the same path as public ones. A typical investment cycle for a private equity fund includes the following five steps:
- Fundraising: To start, private equity firms raise capital from accredited investors, making them LPs in new private equity funds.
- Deal sourcing and due diligence: This step might overlap a bit with the fundraising round, but either way, private equity funds have to search for potential investment opportunities and conduct thorough due diligence before committing millions of their investors' money.
- Acquisition: Once the targets have been vetted and the funding is in place, private equity funds make their acquisitions, either by buying a large stake or companies outright. In many cases, this involves a combination of using investors' cash along with borrowed funds from banks and other lenders to afford buyouts, and the investment period often spans around three to five years before the funds have been fully deployed.
- Value creation: Private equity funds often have a hands-on role in shaping the companies they invest in. Private equity fund managers and their staff often work with the management teams of portfolio companies to improve areas like operations and strategy to ultimately improve revenue, profitability, etc. Private equity funds also might leverage resources within their network of investments, such as seeing if two companies that they invest in have complementary offerings that the two can collaborate on.
- Exit: Lastly, after around three to five years of ownership, most private equity funds try to exit an investment so they can realize returns for investors as opposed to having on-paper returns. Some exit options include an IPO, strategic acquisition from another company, or selling the ownership stake to another private equity fund.
Potential benefits of private equity
Many investors like private equity because it offers the possibility of unique advantages like:
High returns
While not guaranteed, private equity often yields higher returns than public equity. For example, from 2000 to mid-2023, state pension funds that invested in private equity saw net annual returns of 11%, while they would have only gained 6.2% from public stocks during that time, according to an analysis by the CAIA Association.
Active influence
With public companies, the ownership stakes are typically so diverse that one investor doesn't have much say over how the company is run. But with private equity, a fund might be the sole or at least majority owner, so it can actively shape the companies it invests in. That could be attractive to inventors not only for the return potential, but also for those who want to see certain types of companies succeed, like environmentally-focused businesses.
Diversification
Alternative investments like private equity can also help investors diversify their portfolios, which can potentially reduce overall risk. That's because private equity and public companies don't always move in unison, so having some allocations to both could help you have a smoother ride. For example, public equities might experience short-term swings due to the earnings reports of a few large companies, but because private equity typically operates on a multi-year timescale, those short-term influences might not have much effect.
Potential risks of private equity
While private equity offers several possible benefits that attract investors, there are some pitfalls to watch out for, such as:
Illiquidity
Private equity investments are typically illiquid, in the sense that investors often commit to keeping their capital locked up for the duration of the fund or at least a multi-year period. Even if there are opportunities for LPs to sell their stakes, the pool of possible buyers is much smaller than with public equities, which can often be traded almost instantly.
High fees
Private equity funds carry a lot of fees, including both management and performance fees. A typical structure is "2 and 20", meaning fund managers charge a 2% annual management fee while taking a 20% cut of annual returns after clearing a designated hurdle. If all goes well, investors are happy to pay these fees if it means earning more than they could with other investments, but sometimes these fees cut into returns to the point where investors would have been better off with other choices, like low-cost exchange-traded funds (ETFs). Fees can also be complex and obscure at times.
Performance risk
The potential for greater returns can also come at a higher risk, as some private companies lack as much of a track record and broad investor support compared to public companies. So, the risk of issues like bankruptcies could be higher. Plus, when private equity funds engage in strategies like LBOs, the added debt can amplify losses.
Who can invest in private equity?
Because private equity is less regulated and more complex, investment is often restricted to only certain investors who are considered to have the knowledge and/or financial means to take the risk. These include:
- Institutional investors: These are large organizations with significant pools of money, often in the millions or billions, such as pension funds, endowments, foundations, and insurance companies.
- High-net-worth individuals: These generally include accredited investors who have significant financial resources. They might not have enough money to invest in large private equity funds, but some smaller ones might court their investments, which could involve tens of thousands of dollars if not hundreds of thousands of dollars invested at one time.
Limited access for retail investors
Individual investors who are not accredited are often called retail investors, and they usually can't invest directly in private equity funds or even private companies that are openly soliciting investment. However, there are some exceptions. For example, the SEC's Rule 506(b) allows for private sales to up to 35 non-accredited investors in any 90-day period. Also, retail investors might be able to invest through certain crowdfunding campaigns that sell shares in private companies.
Moreover, retail investors might be able to gain exposure to private companies through some publicly traded funds, like some mutual funds and ETFs that either invest directly in private companies or private equity funds, or they might invest in public assets that are correlated to some private assets. Also, some private equity firms or finance companies with private equity arms are publicly traded companies, so you can indirectly gain a stake in their underlying investments.
What to know before you invest in private equity
While private equity investing is certainly not for everyone, for those with the capital, it can be an attractive way to try to achieve higher-than-normal returns.
That said, before you decide to go this route, you'll want to do your research on the fund's investment strategy, its other investments, accompanying fees, lock-up periods, etc. Unfortunately, this information can often be difficult to find, since private equity funds are generally not required to share information as readily as public investment funds, like master limited partnerships, mutual funds, or real estate investment trusts (REITs).
That's one reason why private equity investments traditionally have been the realm of institutional investors and sophisticated accredited investors.
But some of the newer private equity investment options, like equity crowdfunding and private equity ETFs, allow investors of smaller means to play — and get in on a promising startup before it makes its way to the public market perhaps.
FAQs about private equity
How long do private equity investments typically last?
Private equity funds often invest in private companies for around three to five years. Funds themselves often last for roughly seven to fifteen years, after which all capital is typically returned to investors.
What is the difference between private equity and venture capital?
Venture capital typically focuses on early to mid-stage startups, often around the Series A and/or Series B funding rounds, and venture capital funds often acquire minority stakes in companies. In contrast, private equity funds often invest in late-stage startups or fully mature companies, in many cases buying majority stakes or entire companies.
How do I invest in private equity?
Most individuals are ineligible or don't have enough funds to make direct investments in private equity funds or the types of private companies they typically invest in, but broader access may be available through other means, such as publicly traded investment funds that allocate to other private equity funds, or by investing in the stocks of publicly traded financial services companies that have private equity arms.
